VISUAL PLANNED GIVING:
An Introduction to the Law and Taxation
of Charitable Gift Planning

12. CHARITABLE REMAINDER TRUSTS, PART 1 of 4

Links to previous sections of book are found at the end of each section.

Charitable Remainder Trusts are the most powerful and flexible charitable planning vehicles available to donors and charitable planners. These instruments offer enormous potential tax advantages along with enough freedom to address the needs of even the most exacting client with highly peculiar preferences. Unlike Charitable Gift Annuities, Charitable Remainder Trusts are typically individually created to precisely match the plans and preferences of the individual donor. This flexibility does come at a cost, specifically the cost of individually constructing and annually maintaining the trust. But, for large transactions these costs can be relatively inconsequential. Despite the unique nature of most individually-crafted Charitable Remainder Trusts, all must comply with the broad framework from the Internal Revenue Code.

The most common form of a Charitable Remainder Trust is one where the donor places assets into a trust from which he receives payments for life, with any remainder going to charity at death. In the accompanying image, the Charitable Remainder Trust (CRT) is pictured as a basket holding cash. A trust is, essentially, a basket – with instructions – that holds money or other assets. The Charitable Remainder Trust is no exception. The Charitable Remainder Trust is a special kind of trust “basket,” because it is itself a charitable entity. Consequently, the trust pays no taxes on income or capital gains from typical investments. The Charitable Remainder Trust differs from the Charitable Gift Annuity in that it is typically a donor-created vehicle. Whereas Charitable Gift Annuities are issued, administered, and managed by the charity, the charitable beneficiary of a Charitable Remainder Trust may not even know of its existence until receiving the final distribution check.

Although the most common form of the Charitable Remainder Trust is one where the donor sets aside assets from which he or she takes payments with any remaining amount going to charity at death, there are other varieties. For example, the payments need not go to the donor, but could instead go to someone else selected by the donor. The payment recipients (a.k.a. annuitants) could even be a combination of the donor, the donor’s friends or family, or other charities. (However, at least one beneficiary must be non-charitable.)

Although payments are typically made for the donor’s life (or the joint lives of the donor and the donor’s spouse), a Charitable Remainder Trust can pay for any number of lives. Where the Charitable Gift Annuity is limited to a maximum of two lives, no such limitation exists for Charitable Remainder Trusts. (The only requirement being that the individuals were alive at the creation of the Charitable Remainder Trust. This would prohibit a trust that would pay for the lives of “any of my grandchildren, whether currently living or born in the future.”)

Alternatively, a Charitable Remainder Trust can pay for a fixed period of years. However, the fixed period of years cannot exceed 20 years. Thus, Charitable Remainder Trusts can be made to last much longer by selecting payments for a number of lives, rather than a fixed period of years. Additionally, the terms can be combined. Thus, the payment could be made for the donor’s life or 20 years whichever is longer [Treas Reg. 1.664-3(a)(5)(ii)]. This option provides a lifetime annuity with a 20-year minimum payment regardless of actual life span of the measuring life.

There are two types of Charitable Remainder Trusts. The first is a Charitable Remainder Annuity Trust (CRAT). The Charitable Remainder Annuity Trust pays a fixed dollar amount each year (or more frequently) for the life of the trust. In this way the Charitable Remainder Annuity Trust is very similar to a Charitable Gift Annuity. One difference is that the Charitable Remainder Annuity Trust is backed by the assets in the trust, where a Charitable Gift Annuity is backed by the issuing charity. If the assets in a Charitable Remainder Annuity Trust are exhausted (either due to poor investments or exceptional longevity of the annuitant) the annuity payments will cease. Similarly, if a charity becomes bankrupt, the Charitable Gift Annuity payments may be reduced or cease altogether, depending upon competing creditor claims and remaining assets. The relative security of annuity payments from a Charitable Remainder Annuity Trust as compared with a Charitable Gift Annuity depends upon the underlying investments in the trust or the financial strength of the issuing charity, respectively.

Alternatively, payments can be a fixed percentage (between 5% and 50%) of all trust assets. This type of Charitable Remainder Trust is referred to as a Charitable Remainder Unitrust (CRUT). This is the more common type of Charitable Remainder Trust. Unlike the Charitable Remainder Annuity Trust, the Charitable Remainder Unitrust allows the recipient to benefit from investment growth within the trust. The annuity payments in a CRAT are for a fixed dollar amount, but over time inflation can reduce the purchasing power of that fixed dollar amount. If inflation also results in higher interest rates for investments held by the CRUT, then its payments could increase over time, helping to maintain the purchasing power of the payments. Both the CRAT and CRUT are subject to investment risk. The risk in a CRAT is that the payments will cease due to exhaustion of all CRAT assets. The risk in a CRUT is that the payments will become smaller and smaller. The CRUT payment doesn’t normally cease, because its payment is a percentage of the value of all assets currently in the trust. For example, if a 10% payout CRUT were established with $100,000 and the money was held in a non-interest bearing account, the first payment would be $10,000 ($100,000 x 10%), the second would be $9,000 ($90,000 x 10%), the third would be $8,100 ($81,000 x 10%), the forth would be $72,900 ($72,900 x 10%), and so forth. The payments would never actually cease, but would just become smaller and smaller over time. (Although after 132 years the payments would fall to less than one penny, so perhaps then the trust payments would necessarily cease.) A CRUT does not risk complete exhaustion like a CRAT unless the underlying investments became completely worthless due to market events.

A donor can transfer cash or property to a Charitable Remainder Trust. Most commonly, this transfer is of appreciated property. As we will see later, the attraction for transferring appreciated property is that such transfers can avoid capital gains taxes, but still allow the donor to receive payments from the undiminished proceeds of the sale of the transferred property. Transfers to Charitable Remainder Trusts can include cash, shares of stock (other than subchapter S corporation shares), bonds, limited partnership interests, real estate, tangible personal property, and almost any other asset.

The donor creates the rules in a Charitable Remainder Trust, so long as those rules fit within the general guidelines for Charitable Remainder Trusts established by the Internal Revenue Code. This enormous flexibility, however, ends after the trust is created. A Charitable Remainder Trust is an irrevocable trust. Once the rules are created, the rules cannot normally be changed. This irrevocability is what allows the Charitable Remainder Trust to become a charitable entity (i.e., it cannot later be made less charitable). Irrevocability also allows the donor to take a tax deduction for his or her transfer to the trust.

The importance of irrevocability arises in other areas of charitable planning as well. A donor receives no income tax deduction for having a charitable beneficiary in his or her will because the donor could, at any point, remove all charitable beneficiaries. In contrast, when the donor transfers a remainder interest with retained life estate in a home or farm to a charity, the donor can take an immediate tax deduction, even though the charity will not become full owner of the property until the death of the donor. The key difference between a will and a remainder deed is that the will is revocable, and the transfer of a remainder deed is not.

Although the donor loses the ability to change the rules of the trust once it is created, the trust rules can still provide for ongoing donor influence in several areas.

In many cases, the donor may act as trustee of the Charitable Remainder Trust and continue to manage the assets and investments. There are certainly guidelines that must be followed to ensure that the donor is not receiving any additional benefit from the trust or engaging in self-dealing, but there is no prohibition against a donor managing his or her own Charitable Remainder Trust. Alternatively, the donor may instead choose who the trustee will be and keep the ongoing power to appoint or remove trustees. The donor could select a friend, a family member, a trust company, or even a charity to serve as trustee of the trust.

However, some plans will require the use of an independent trustee. For example, the donor may not act as trustee if the trust allows for payments to be withheld or shifted amongst various non-charitable recipients. This keeps too much power with the donor, and causes the trust to be treated as simply the property of the donor.

Although the donor may not keep any rights to change which non-charitable beneficiaries receive payments (or the amount of those payments), the donor is permitted to decide which charity will receive the remainder interest at the termination of the Charitable Remainder Trust. The Internal Revenue Code requires only that the remainder interest ultimately goes to some charity. The donor could even choose for the remainder interest to go to a private foundation. Thus, the donor could establish a Charitable Remainder Trust payable to a university, retain the right to change the charitable beneficiary, and later establish his own private family foundation and declare that foundation as the new charitable beneficiary. (If the donor keeps the right to name a private foundation as the charitable beneficiary, charitable deductions resulting from transfers to the trust will be subject to the income limitations for gifts to private foundations.)

This flexibility to change charities is available, but not required. It is perfectly acceptable to have a Charitable Remainder Trust where the remainder beneficiary cannot be changed (unless, for some reason, the remainder beneficiary no longer qualifies as a charity at the time of the termination of the trust). Indeed, most charities will not agree to act as trustee of a Charitable Remainder Trust unless they are named irrevocably as the remainder beneficiary.

Given the flexibility of the Charitable Remainder Trust, it can be a useful tool for donors with a variety of financial goals and circumstances. The ability to take payments from the proceeds of highly appreciated assets – undiminished by capital gains taxes at their sale – accompanied by tax free growth of investments inside of the Charitable Remainder Trust along with receiving an immediate tax deduction for a post-mortem transfer make this an enormously attractive vehicle for the charitably-inclined donor with appreciated assets. Several common financial planning scenarios correspond almost exactly with the terms available in a Charitable Remainder Trust.

A donor who wants a fixed annual payment from investment assets and also wants to make a post-mortem gift to charity is an ideal candidate for a Charitable Remainder Annuity Trust. The Charitable Remainder Annuity Trust not only provides for fixed annual payments and an ultimate transfer to charity but, as compared with using a standard investment account and will, can produce enormous tax benefits.

The Charitable Remainder Unitrust is well suited for the donor who wishes to retain control of his or her investments. Not only can the donor retain control, but with the Charitable Remainder Unitrust, the donor also receives larger payments when assets grow in value. Where a wealthy client has a pre-existing desire to leave a bequest gift to charity at death, the use of a Charitable Remainder Trust will often be, by far, the most tax advantageous way to accomplish the client’s other financial goals.

Although the most common form of Charitable Remainder Trusts pay for a life or lives, in some cases the fixed term trust can be ideal. If a client desires to make a substantial lifetime transfer to charity, but still has specific income needs for a fixed amount of time, the fixed term Charitable Remainder Trust can be an excellent solution. Such fixed-term payments can help to address a temporary income need due to early retirement or to a known obligation such as college tuition for a child or grandchild.

Although it is quite common for clients’ to have financial planning needs that correspond with the allowable terms under a Charitable Remainder Trust, such needs could also be addressed without the use of the trust. For example, a donor could simply set aside money into a special account, withdraw annual sums from the account, and designate a charity as the “pay on death” designee. Functionally, this would work exactly like a Charitable Remainder Trust, except that the donor would retain 100% control and freedom. So, given this simple alternative, why would a donor choose to use a Charitable Remainder Trust? The answer is simple: tax benefits.

At its core, the Charitable Remainder Trust is attractive not just for its correspondence with the donor’s pre-existing plans and goals, but rather for the special tax advantages that are otherwise unavailable. The wide range of tax benefits generated by the Charitable Remainder Trust is what drives its widespread use.

An initial and obvious benefit from using a Charitable Remainder Trust is that the donor receives an immediate income tax deduction for a transfer that will not go to charity for many years. Without using a Charitable Remainder Trust, the donor could still set aside an asset, take payments from the investment for 20 years, and donate whatever is left to the charity. But, the donor would have to wait 20 years before receiving a charitable income tax deduction. Even worse, if the donor wanted to take payments from the investment for life, donating whatever remained to charity at death, then the donor would never receive any charitable income tax deduction. The Charitable Remainder Trust allows a donor to immediately take a deduction in both of these scenarios even though the ultimate charitable beneficiary may not see funds for many years. This ability to create a large charitable income tax deduction where none would have existed before (or in some cases to pull forward those deductions by two decades) is very powerful. Additionally, as discussed later, the valuation of the deduction for post-mortem transfers is actually much higher than is actuarially appropriate given that wealthy donors, on average, live much longer than the typical person. Results from the Health and Retirement Study reported in American Charitable Bequest Demographics indicate that wealthy bequest donors live 5-7 years longer than poor non-donors do. Additionally, those who purchase lifetime annuities live longer than others of their age because the annuity-purchasing group typically excludes those who are seriously ill or known to be approaching death. Both of these factors point to the reality that Charitable Remainder Trust donors will, on average, live substantially longer than others of their same age. For tax deduction valuation purposes, this means donors will receive a deduction based upon their receiving payments for a much smaller number of years than will typically be the case (i.e., the tax deduction is greater than is actuarially appropriate).

Regardless of the actuarial discussion, there is no doubt that the income tax deduction available for making a post-mortem charitable transfer by a Charitable Remainder Trust is greater than that for making the same transfer by will. This is obvious because a charitable transfer by will generates no charitable income tax deduction. The Charitable Remainder Trust donor does give up some freedom in exchange for the tax deduction; he cannot later decide to give the charity’s share to a non-charitable beneficiary. In contrast, a will – although generating no charitable income tax deduction – can be completely changed at any time prior to death.

One of the great sources of tax advantages available from a Charitable Remainder Trust relates to the postponement or avoidance of capital gains taxes. Critical to this advantage is the reality that donors may transfer highly appreciated assets to a Charitable Remainder Trust without triggering recognition of capital gain. This is simply another application of the general principle that donors can give highly appreciated property to a charity, recognize no capital gain, and in many cases take a tax deduction based upon the full fair market value of the property. This fundamental tax benefit is why donors normally should give appreciated property, rather than cash (especially where the appreciated property is a fungible asset such as publicly traded stock where replacements can be immediately repurchased with a higher cost basis). The Charitable Remainder Trust takes this basic advantage and applies it to a scenario where the donor not only makes a gift, but also receives a stream of payments from the gift.

The capital gains tax advantage from a Charitable Remainder Trust is not limited to the ability to transfer appreciated assets into the trust without generating capital gain. The Charitable Remainder Trust is itself a nonprofit entity. As such, the trust can have capital gains and earn income while paying no taxes. This creates two dramatic tax advantages. First, the donor can take payments from the full sale value of the highly appreciated asset, undiminished by capital gains taxes. (Whereas, a sale outside of the Charitable Remainder Trust would immediately cut the remaining amount available to invest.) Second, all future investment growth taking place inside the Charitable Remainder Trust occurs without taxation, excepting only potential taxation on the payments received by the donor. This makes the trust a perfect environment for the tax-free growth of assets, similar to a qualified retirement plan.

Without looking at the numbers in a few scenarios, it may not be immediately obvious why the ability to receive payments from the full sale amount of a highly appreciated asset can make such an enormous difference. So, let’s turn to some examples to demonstrate this power.